(U) This document is sensitive but unclassified. Please protect
accordingly. Not for release outside U.S. government channels. Not
for internet publication.

1. (SBU) Summary: Factory closures, especially those like Smart
Union in the toy industry, have become topic one in south China,
especially in the Pearl River Delta. Local governments are now
scrambling to identify other factories that might be on the verge of
shutting down; many of these have been in trouble for months, if not
years, and their situation is not directly attributable to the
spreading financial crisis. While some top tier firms are
expanding, it seems likely that the longer the crisis persists, the
worse the impact may be on the PRD. At this point, as elsewhere in
country, job loss and the corresponding impact on social stability
are being closely watched by the leadership. End summary.

2. (U) Smart Union, a large Hong Kong-listed OEM toy manufacturer
announced the closure of three Guangdong Province factories on
October 15. Two of the factories were in Zhangmutou County of
Dongguan City, a sprawling manufacturing community in the heart of
the PRD. The company's other factory was located in Qingyuan, north
of Guangzhou. The situation intensified a day later as workers
gathered in front of the closed factories and local government
offices to demand their unpaid wages. Images of the protesting
workers aired on Hong Kong television broadcasts that evening and
subsequently on news broadcasts around the world.

3. (U) In addition to Smart Union, at least four other Hong
Kong-listed manufacturing companies have also recently closed their
doors and left as many as 8,600 unpaid workers in the last week.
More than 1,500 laid-off workers protested outside a Shenzhen
factory run by bankrupt small appliance maker BEP International.
Another factory, watch maker Peace Mark, closed its doors on more
than 500 workers in Longhua; media report that another 600 workers
staged two days of sit-ins at an affiliated factory in Xixiang
Township of Shenzhen. Managers from each closed factory are
reported missing and suppliers to some of the factories are filing
lawsuits for delinquent payments and damages.

4. (U) Although local governments have varied slightly in their
response to the closures, all have been eager to go after deadbeat
employers and help the laid-off workers. Zhangmutou County
announced October 17 it would pay wages of approximately 6,500 laid
off Smart Union workers, with RMB 24 million (USD 3.5 million) in
payments disbursed to the company's former employees on October 21.
Local authorities have so far not been able to locate managers of
the failed companies, an all too common situation in south China's
labor-intensive manufacturing industries (ref A). Guangdong
authorities have publicly accused companies of "premeditated"
factory closures, with Vice Premier Zhang Dejiang, former Guangdong
Party Secretary, reportedly ordering a full investigation after
directing local and provincial authorities to cover the unpaid
wages.

5. (U) Local governments have also stepped up efforts to identify
other potentially insolvent factories by publishing the names and
key information about those who have failed to pay their workers.
On October 21, Shenzhen published a list of 30 companies that
collectively owe their employees RMB 12 million (USD 1.75 million)
in back salaries. Two thirds of the companies listed are located in
Shenzhen's Longgang District and represent a variety of industries
including plastics, apparel, real estate and furniture. Local press
has reported that managers for most of the factories had fled after
their information was published, and the government allocated money
from its Wage Security Fund to help cover deficits. Dongguan and
Zhongshan have also published similar lists in recent years.

SUBJECT: Toy Factory Clowuse"Gav),tknQ$MQ regularly with all of its first-tier
toy suppliers to discuss financial issues, plan new projects and
improve safety and efficiency. Smart Union executives contacted the
western firm 6-8 weeks before the factories closed to brief
executives on its precarious financial situation. The two companies
agreed on a plan to gradually reduce the buyer's exposure while
contracting for new orders of lower-tech toy lines to help the
supplier maintain cash flow and production capacity. The western
firm began removing proprietary molds and tools shortly after the
discussion with Smart Union executives, and completed the process
two weeks before the factories closed.

7. (U) Southern Metropolis News (Nanfang Dushi Bao) published an
in-depth analysis of the Smart Union collapse (the company may have
owed as much as RMB 227 million, USD 33 million, to suppliers and
workers) that identified many internal factors that contributed to
the company's failure. Among internal causes, the paper claims
Smart Union faced financial problems after losing RMB 67.5 million
(almost USD 10 million) when its factory flooded in June 2008,
destroying inventories and forcing a one-month closure. Rumors have
also circulated that Smart Union lost RMB 269 million (USD 39
million) on failed investments in a major Chinese mining company, or
possibly in the stock market. In addition, news reports said
trading of the company's Hong Kong-listed shares were suspended
following a fifteen month decline that ended with shares valued at
RMB 0.099 (USD 0.014) each.

8. (SBU) According to the western toy company executive, Smart
Union's failure was an unusual case because of the speed with which
it went from having "cash-flow problems" to insolvency, unusual
especially for a relatively large publicly-listed Hong Kong company
with a well-known reputation as a profitable, first-tier toy maker
that supplied top-tier overseas clients. He said most other recent
toy industry failures were among smaller second- and third-tier
firms, many of which were not publicly listed and would never
qualify to supply a major buyer like his company. A Nike executive
reinforced this notion, commenting to us recently that the factories
closing down in the PRD are not part of the firm's supply chain.

9. (SBU) At the same time, the western toy company executive
commented that his top suppliers are faring well despite all of the
long term economic pressures, and several major toy firms are
expanding within the PRD and in other areas of Guangdong Province as
opportunities arise. The executive said he buys approximately 75
per cent of his toys from a select group of 15 top suppliers,
spending almost USD 1 billion per year on those suppliers of a total
USD 1.3 billon procurement budget. He pointed out that his
company's earnings statement this week showed strong third quarter
results and should not be affected by current economic conditions in
south China, even as more small firms close and consolidate.

...and Part of a Trend
----------------------

10. (SBU) As has been widely reported, many external factors also
drove Smart Union's demise and are squeezing labor-intensive
manufacturers in the PRD. Many of these are challenges that are to
be expected in a maturing manufacturing sector, such as rising
wages; higher raw material costs; appreciation of China's currency;
tighter regulation, ranging from the new Labor Contract Law to
stricter enforcement of environmental laws; and higher product
safety standards after last year's toy recalls (ref B). Other
factors include policies aimed directly at labor-intensive export
manufacturers, like reductions in the value-added tax rebate (though
apparently the Chinese government has recognized this problem and
has increased VAT rebate for a variety of exports from textiles to
furniture to toys). These are consistent with Guangdong's "double
transfer" economic strategy aimed at pushing labor-intensive
manufacturing and its workforce out of the PRD and into less
developed areas of the province.

11. (SBU) These factors are largely independent of the global
financial crisis, and there are today fewer media reports that
attribute Smart Union's collapse to the global financial crisis.
However, another key factor is slowing demand for China's exports.
Manufacturers have been complaining about this for months, often
arguing that U.S. buyers aren't willing to pay enough for their

GUANGZHOU 00000618 003 OF 003

products (ref C). Smart Union's troubles started well before the
most recent turmoil in global markets, but there are clearly
expectations in the PRD that the market outlook for China's
exporters will continue to deteriorate. Many observers are
predicting that thousands of toy factories and other
foreign-invested manufacturers will close by year's end (ref B).

Comment: Harbinger of a Crisis?
-------------------------------

12. (SBU) The difficulties currently facing the PRD's
labor-intensive manufacturing industries are by no means new or
unexpected. However, the global financial crisis suggests that they
may become worse than previously anticipated. With factories
currently filling orders placed months ago, we have not yet begun to
see the full impact of the crisis on south China's exporters.

13. (SBU) The answers to many questions about the future of the
"world's factory floor" will remain unclear until that impact starts
to emerge. What does this mean for Guangdong Party Secretary Wang
Yang's "double transfer" vision? It appears that officials are
already looking at ways to mitigate the forces pushing factories out
of the PRD with new policies aimed at helping small and medium
enterprises. In explaining the policy, many have cited the Chinese
expression of "emptying the cage and changing the bird." (ref D)
Now some of our contacts are talking about "expanding the cage and
strengthening the bird" instead. What will the new approach look
like?

14. (SBU) More importantly, how will laid-off workers react to their
changed circumstances? This confronts PRD officials with a critical
challenge: they are ready to compensate the unemployed to maintain
stability, but will their efforts be enough?